01st May 2020 by Helge Kostka

Small Cap - Small is still beautiful

Small Cap

With recession concerns intensifying in the wake of the COVID-19 pandemic, investors may be wondering whether small cap stocks are poised to struggle further. Small cap stocks this year have been hit by even greater fear than other parts of the equity market. Comparing the MSCI All Country World index (ACWI) with its little brother, the ACWI Small Cap Index, shows that the large and mid-caps global mix held up 8.7% better than global small cap in the first quarter of 2020. But even if the economy has entered a recession, it does not necessarily follow that small cap stocks should underperform. Why? Current market prices already reflect expectations about future cash flows, including any impact of an economic downturn. So even if the effects of a recession are more heavily borne by smaller companies, small cap stocks can still deliver higher expected returns.

What is small cap?
Some investors are questioning if these small firms will even survive the shutdowns. This may not seem so impossible as, where retail is concerned, all small businesses are closed so these firms must be most affected.

Perhaps it is useful to start by describing what is considered a small cap stock. Small caps defined by MSCI cover around 14% of the market capitalisation in each country, from the bottom 85th to 99th percentile. That is a total market segment of $4,872 billion. Small cap is therefore economically meaningful.  The average company in the ACWI Small Cap Index has a market cap of $821 million and the largest company exceeded $10bn at the end of March. Small cap is also hugely diversified, consisting of almost 6,000 stocks and the largest 10 index constituents combined have just a 1.77% index weight. Small Cap shares are not micro cap – micro cap are the bottom 1% of market cap in each country. Comparing that with Microsoft and Apple, which each account for more than 2.8% of any investment in MSCI ACWI, we can conclude that small caps are a useful long-term addition to any equity portfolio allocations, regardless of the motive to generate a return premium over the market.

Small cap companies are not more vulnerable now
The first question we want to answer is whether small cap companies were displaying any unusual trends leading into the current crisis. If the financial characteristics of small cap firms in recent years have been in line with long-term averages, we can use historical data to help us understand the potential range of outcomes going forward.

One common measure of a company’s relative strength is its leverage, or the relative value of its debt. A company whose financial standing has deteriorated during an economic downturn may experience rising leverage that is less sustainable over a long period. However, as DFA recently analysed in a new publication this week, aggregate leverage rates for US small caps have in fact been similar to those for US large caps, and relatively stable over time.

They also assessed the proportion of companies with negative earnings. A company with negative earnings going into a recession may face worse odds of persevering through the downturn. Recently, about 25% of the US small cap market reported negative earnings, compared with about 5% of the US large cap market. However, this is not a particularly new development; the current proportion of US small caps with negative earnings is in line with the norm over the past several decades, both in absolute terms and relative to US large caps.

Historical data on stock de-listings suggests that, on average, the stocks of small cap firms tend to be delisted for “bad” reasons, such as liquidations, bankruptcies, or inability to meet exchange listing criteria, more frequently than large cap stocks. From 1927 to 2019, the average annual rate of so-called bad de-listings for US small cap stocks was about 2.7%, more than six times the rate for US large caps but that rate tends to be higher around economic recessions. The relevant question for investors is whether this pattern will impact the future performance of small cap stocks. It is important to remember that even if, as expected, small companies are entering bankruptcy more frequently than larger companies, it doesn’t necessarily imply that returns for all small companies in aggregate will be lower. Rather, it is sensible to believe that the expected return for small cap stocks as an asset class compensates for the possibility that some individual companies may go out of business. The DFA research piece demonstrates that there is no relationship between the rate of de-listings and the expected return premium of small caps over large caps.

More than one return premium in small cap stocks
For the small cap premium - also called size premium - academia agrees that the difference between returns from large cap versus small cap stocks is as a result of additional risk. Fama and French (1992) argue the additional risk is due to higher capital constraints of small cap companies. Arnott, Hsu, Liu, and Markowitz (2015) concluded that the small cap premium exists because small caps are more likely to be cheap. The small cap segment of the equity market is often deemed less efficient because of arguably lower investor interest as well as lower liquidity.

Most importantly, as demonstrated in Beck, Hsu, Kalesnik, Kostka 2016, other return premia such as value tend to exhibit stronger empirical evidence in smaller companies. The table below shows the return and risk findings for US equities, broken down into large cap and small cap, as well as value and growth, with various definitions of value.
 
US data, 1967–2014 Value Growth
Definition Return Volatility Return Volatility
     
Large        
Book to price 13.1 16.7 9.3 16.8
Earnings to price 13.3 16 8.8 17.8
Cash flow to price 13 16.3 9.2 17.3
Dividends to price 12.7 13.9 9.4 20
         
Small        
Book to price 16.6 23.2 10.5 22.8
Earnings to price 15.9 20.7 10.2 25.3
Cash flow to price 17 22.5 10.2 23.1
Dividends to price 15.4 16.7 11.2 25.1
     
 
Source: Noah Beck, Jason Hsu, Vitali Kalesnik, Helge Kostka. 2016. “Will Your Factor Deliver? An Examination of Factor Robustness and Implementation Costs” Financial Analyst Journal, Vol. 72, No. 5: 58–82.

Comparing top to bottom, volatility is higher for both growth and value small cap versus their large cap equivalents. And so are their returns. Comparing left to right, value has done better than growth but the difference is much larger for small cap stocks. This result is very robust as it does not change much when the definition of value is varied.

Trusting in the above results and similar findings, our clients are not just invested in small cap exposure, they are exposed to small cap with a value tilt. In fact, the small cap funds MASECO prefers are even more refined. Those strategies prefer small cap value companies which have exhibited relatively high levels of profitability and relatively low asset growth of investment. These additional tilts towards higher “quality” companies are based on more recent research findings by Novy Marx (2014) and Fama and French (2016).

The Winner’s Curse
One should always look at both sides of a trade to understand relative performance. We know that value did not do well recently, and we also know the same is true for small cap. Small cap value stocks performed the worst. When the 1.45% positive return for the Morningstar growth index over the last 12 months is broken down into small, mid and large cap, large cap growth delivered a gain of 2.29%, while small cap growth stocks lost 16.07%. So, even inside the growth segment of the US equity market performance, differences were huge depending on company size. Therefore, we need to look at large cap growth stocks to understand relative performance of small cap, and particularly small cap value.

Mega cap is the extreme end of large cap. Within indices, their performance drives most of the index performance due to their high percentage weighting in any index. Looking at MSCI ACWI again, the top 10 holdings are the biggest companies in the world by market capitalisation. Just these 10 out of over 3,000 index constituents make up a combined 13.77% index weight, a concentration risk surely everyone must agree with. All of these companies feature on the news almost daily. Just to give their flabbergasting size some perspective, let’s look at the FANMAGs, an acronym chosen for Facebook, Apple, Netflix, Microsoft, Amazon and Alphabet Inc’s Google. As can be seen below, their combined market cap of nearly $5 trillion at the end of last quarter exceeds that of Japan, the 3rd largest economy in the world. They now account for nearly 20% of the market cap of corporate America.

Source: Source: MSCI, based on index data as of 31/03/2020. FANMAG market cap data collected from ycharts.com as of 31/03/2020

These companies have definitely been very successful and, on paper, their stocks have so far created huge wealth for investors. But what return can one expect from them in the future? Remember, their current price already contains all information and high expectation about their future growth. So, merely meeting those expectations will result in 0% return.

When one compares the top 10 companies at the start of each decade over the last 40 years, one notices that only 2 companies have been on that select list three times or for a time span of 20 years: Exxon Mobil and Microsoft (white). Most firms entered the list and were not on it 10 years later (blue). Walmart and NTT were an entry (green) and managed to stay on the list once more 10 years later (red).

Source: Research Affiliates, “Are Valuations Now Irrelevant?”, Oct 2019

A great piece of research called the winner’s curse has shaped my expectations of what might happen to most of the FANMAGs. Crunching the return data behind market cap rankings in the developed markets, the research paper revealed the statistics in the diagram below. The explanation for the abovementioned changes is surprisingly rather simple: the historical ‘top dogs’ underperformed after reaching their relative peak in market capitalisation. Only in 1 out of 20 cases did the largest stock by market cap outperform the market over the 10-year period after it reached that position. On average there was 10.5% annualised underperformance. The study shows similar results when looking at individual countries. The below also shows results of the biggest stock in any sector of the G8 countries. While not quite as terrible, 5% underperformance each year for 10 years is also quite a striking result.

Source: Rob Arnott,  Lillian Wu, 2012. "The Winner's Curse." Journal of Indexes (October 29)

When I answer questions about what might lead to such underperformance, I usually quote the analogy of any sporting competition. Of course, becoming the number one ranked tennis player in the world is an amazing achievement. But once that person has reached the top, every competitor will try even harder to knock them off the top spot. That person is also less motivated having reached the maximum achievement, perhaps even getting lazy or sloppy. In the corporate world, a very large company is also more scrutinised by the media. The company becomes harder to manage. Some of the best talent might be hired by competitors and regulators and international governments are beginning to take an aim in respect to their market power and monopolistic behaviours.

What is to come?
In the US market, there have been 261 10-year periods when the size premium were negative (27% of all 10 year time periods since 1927). As can be seen below, the small cap premium was considerably positive, on average, throughout 10-year time periods following 10-year negative periods, beating the market by 4.64%.

Past performance is no guarantee of future results.

Using monthly return data from June 1927 to December 2018, annualised premiums are calculated over the subsequent 10-year periods following a negative 10-year size, value, or profitability premium. The average, minimum, and maximum are calculated across all such 10-year periods for each premium. Excluded are 10-year periods that end after December 2018. Indices are not available for direct investment, their performance does not reflect the expenses associated with the management of an actual portfolio. (Dimensional US Small Cap Index minus the S&P 500 Index).

Source: Dimensional, As At March 2020

Price/Earnings ratios of small cap stocks are now lower (cheaper) globally than they have been at any time over the last ten years.   On average, paying for $1 of earnings from a small cap company was also cheaper than paying for $1 of earnings from a large cap company in every one of those regions. As usual we cannot predict what will happen and when but, in our opinion, the odds are stacked in favour of a recovery of relative performance by small cap stocks.

Furthermore, small cap has a valid role to play in all portfolios with equity allocations. It increases diversification and improves the economic footprint of the market. Evidence for a currently increased level of vulnerability of small cap is so far scarce and the small cap approach pursued by most MASECO investors takes into account the recent academic conclusions, which should help relative performance further.

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Performance: 

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